Six high profile employees of hedge funds, IBM, Intel and the consulting firm McKinsey were arrested for insider trading. The case against them stems from a 2007 earnings report released by Google in which quarter profits were lower than expected. It would seem that someone at Google released this information a little ahead of time, which caused a couple of hedge funds to sell Google short. Since then, eight other trades were illegally made and all nine actions made a profit of $25 Million.
Insider trading by definition is not illegal. The term was derived for employees of companies that traded shares from within. Insider trading is only illegal if two principals are met.
- First, the information used when making trades must be material and non-public.
- Second, revealing or trading upon this information must knowingly breach a duty of “trust or confidence”
Whether a specific set of circumstances constitutes illegal insider trading can be extremely difficult to assess. Ultimately, one should consult an attorney to understand whether any given trade or communication of information will run afoul of applicable laws. But to better understand the fine line between legal and illegal, here are four hypothetical situations:
Example #1 – John Johnson, the CEO of Company 1, just came out of a meeting with his financial team in which the company profits are $0.50 higher than expected. Quarter earnings reports are due to the public in three days and John decides to buy 5,000 shares just days before the reports are released. By having material, non-public information that the company is performing better than expected and using it to make a trade, Mr. Johnson has conducted an illegal trade.
Example #2 – Bobby Roberts, the CFO of Company 2, learns that his company is tanking. The patent they needed to release their new toothbrush technology did not come through and his 10,000 shares are sure to tumble. Knowing that if he sells these shares before the public is alerted about the patent problems he will be breaking the law, Bobby decides to sell his shares a day after the information is made public, minimizing his imminent losses. Because Bobby is a high-ranking employee, selling a large number of shares, he will probably have to report this trade to the regulatory committee making this a legal trade.
Example #3 – Thomas Street is celebrating his 25th wedding anniversary with his wife at a fance restaurant. They are seated next to the CEO of Company C who has nothing but a smile on his face. While eating Thomas overhears the CEO telling his fellow employees that they can expect good raises in a couple of weeks because they profits are through the roof and there’s no stopping them. Thomas rushes home and buys 1,000 shares of Company C making a ton of money. Even though he had information that was not public, it was through no fault of his own and the meeting that the CEO and fellow employees had was not designed to leak information. The outcome is very legal and very profitable.
Example #4 – Marcos Padilla goes to a bar Friday night after work where a random fellow asks him if he wants to make a lot of money. Naturally, Marcos is interested and listens to the gentleman tell him that he has a tip on a cold stock. Company D is about to be prosecuted for fraud and their shares are likely to plummet. Marcos also learns that this tip comes from a financial analyst with company D so it’s legit. If Marcos decides to sell this stock short, he is breaking the law as this is defined an illegal insider trade. Should Marcos not have been informed where the tip comes from, there’s a good chance he wouldn’t be prosecuted however knowing the information came from a member inside the company is a big no-no.
You can see from the examples above that prosecuting individuals that commit illegal insider trades is extremely difficult. The best deterrent remains the stiff penalties given in these high profile cases. Several times a year, every public company has the potential to give away insider information making the policing of it nearly impossible. Bottom line is that if you are lucky enough to come across information in good faith, just make sure to keep it to yourself. And if you question whether trading on certain information is proper or not, consult an attorney experienced with insider trading laws.
Published or updated October 29, 2009.